Why The Pain Isn't Over Yet for Emerging Markets

Emerging markets took a beating last year, and despite a recent respite, the pain likely isn't over.

Here's what you need to know.

The MSCI Emerging Markets Index index, which tracks stocks in 24 emerging market economies, lost 14.6% in 2018 versus a loss of 4.4% for the S&P 500. The exchange-traded funds that track emerging markets, such as the Vanguard FTSE Emerging Markets (VWO - Get Report) and the SPDR Portfolio Emerging Markets (SPEM - Get Report) , underperformed similarly.

Emerging markets (EM) include those economies that tend to be less developed than those in Western Europe such as Germany, and U.K. for instance, or the U.S. and Canada in North America. They tend to have faster-growing economies than do developed markets. Countries considered to be in the EM group include Brazil, China, Russia, India, Indonesia, as well as many others.

Despite the plunge in EM stocks last year, the sector has recovered from the lows over the last few weeks. The MSCI EM index gained 8.8% in the month through January 31.

That said, EM investors should brace themselves for more losses. Here's why:

International Trade

The trade-war between the U.S. and China is hurting emerging markets. Both economies are slowing down.

It used to be said that if the U.S. economy caught a cold then the rest of the world would get the flu. There's still a lot of truth to that but there's an added factor.

The communist country is now the world's second largest economy and it imports massive quantities of raw materials, many of which are from emerging market economies. For instance, it buys iron ore from Brazil to make steel which is used in the construction industry.

China's softening economy is being made worse by the still unresolved trade war with the U.S. and that is having a knock-on effect. "There's been a synchronized slowdown in trade between the U.S. and China," says Harrison. "And emerging markets exports are now much lower."

That fall in exports will be a headwind to many emerging markets stocks, at least until trade picks up again.

Heavy Oil Prices

Many emerging market economies rely heavily on exports of oil and other energy resources, and unfortunately for them the outlook for a rebound in crude prices is bleak.

"The world is awash in oil," says Adam Johnson, author of the Bullseye Brief financial newsletter, and a former professional oil trader. "For the first time in history, all three of the biggest global producers -- the U.S., Saudi Arabia, and Russia -- are pumping more than 10 million barrels a day each."

In other words, there's no shortage of energy and hence prices won't likely rally anytime soon. Suppressed oil prices could hamper the economies of Brazil, Russia and Mexico, for instance, all of which export the stuff.

King dollar

But perhaps most damaging of all for the sector is a likely resumption of the dollar rally. Emerging markets stocks tend to sink when the value of the dollar rises.

In 2018 the value of the dollar index increased to 90 from 88, which coincided with the 14.6% drop in the MSCI EM index. Conversely, when the dollar weakened from 95 to 90 in 2017 the same index surged 37%. These are not isolated incidences.

The dollar is likely to resume its surge. Stamford CT-based financial research firm Hedgeye Risk Management says it remains in a long term bullish trend. The firm points to slowing growth and low inflation.

Investors increasingly get attracted to U.S. Treasury bonds when the world economy slows down. To buy those securities they need dollars and that bids up the value of the greenback. In turn, that surge in the dollar acts as a magnet for capital which typically floods into the U.S. from more fragile economies such as those designated as emerging markets.

With reduced levels of capital, emerging markets economies will see a slowdown and their stock markets will likely underperform.